Market resilience: strength in numbers

Transcription

1 Market resilience: strength in numbers FRANKLIN TEMPLETON THINKSTM GLOBAL INVESTMENT OUTLOOK MARCH 2019 Top market risks Global growth expectations Trade conflicts Preparing for volatile shocks ahead Not FDIC Insured May Lose Value No Bank Guarantee

2 Concerns about where the financial markets are heading are at the forefront of many investors minds. The risks of a US or global recession this year continue to persist amid slowing global growth, trade tensions and worries about potential geopolitical shocks. Recognizing uncertainties, central banks globally including the US Federal Reserve have turned a bit more dovish, causing markets to price out US interest-rate hikes in Featured senior investment leaders, Ph.D. Chief Investment Officer, Franklin Templeton Fixed Income Stephen H. Dover, CFA Head of Equities Our senior investment leaders see a different story unfolding. In this roundtable discussion, they outline why they think some market observers are misguided and where they see opportunities today. Discussion topics within: Top market risks Global growth expectations Trade conflicts Preparing for volatile shocks ahead, Ph.D. Chief Investment Officer, Templeton Global Macro Edward D. Perks, CFA Chief Investment Officer, Franklin Templeton Multi-Asset Solutions WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments. Interest rate movements may affect the share price and yield. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.

3 Market risks are top of mind for many. What are your biggest concerns today? Let me start with what I m most concerned about it s complacency. There is an enormous amount of complacency. Within days of US Federal Reserve (Fed) Chairman Jerome Powell s turnaround in thinking earlier this year, markets not only priced out all interest-rate hikes in 2019, but see the next move as a rate cut next year. There is an idea that the Fed is going to be propping up the stock market on an ongoing basis. For me, that is very frightening. We saw an increase in market volatility at the end of last year, but clearly that is not enough if the markets are still not pricing in what I think is a very real possibility of additional rate hikes on the back of what s happening in the economy. That s where my greatest concern would be. I completely share that view. US Treasury yields should go higher for many reasons: growing fiscal deficits, rising inflationary pressures, strong US growth and fewer foreign buyers. When that happens, we will likely get another interest-rate-led shock to broad assets. We think investors need to prepare for that risk. One way to do it is through assets that are negatively correlated to rate rising, and the other way is through idiosyncratic opportunities, which in our case take the form of a select group of emerging market countries. Ironically, there is a negative feeling about some of the state of the world, but for active managers, this is actually very fertile ground to take advantage of. I think equity investors have been thinking a bit too much about the Fed and looking at this as sort of a Fed put, to use an options-related term, meaning the Fed is providing a type of insurance on the market going down. Traditionally, equity investors would look at earnings and the ratio of those earnings to stock prices. I think the last 10 years of monetary policy has made a lot of investors more macro-oriented rather than micro-oriented. They are not really looking at the differences in stocks. In regard to emerging markets, I agree that they are so different and there are many different opportunities. The one thing I would look at in equities is China. I think there are some opportunities there, not just because of the economy and the growth story, but because of how the market is being looked at really has changed. Ed Perks The multi-asset portfolios really blend a lot of these themes. One statement I can make that reflects how we are thinking about our portfolios today is how do we US GDP GROWTH DRIVEN BY CONSUMPTION GROWTH GDP Rate and Consumption Growth Rate December 31, 2008 December 31, % 1.00% 0.50% 0% -0.50% -1.00% -1.50% -2.00% prepare for what s next? We do have a lot of transition happening in the markets, and I think it s incumbent upon us to ensure that we can react to opportunities that markets are inevitably going to give us as volatility increases. There have been some recent signals that might suggest US economic activity has been bottoming and that we are starting to see some normalization. I think there has been too much bearishness, and this view that the United States is about enter a recession is overstated. However, I do think there are some growing concerns fundamentally about long-term sustainability particularly the massive, reckless deficit spending, and the populist politics that can lead to uncoordinated and often-volatile economic agendas. But in the short term, a strong labor market and supportive consumption drive US economic activity, which gives us some comfort % Private Consumption Growth (Quarter over Quarter, %) Real GDP Growth (Quarter over Quarter, %) Source: Franklin Templeton Capital Market Insights Group, FactSet and US Bureau of Economic Analysis. Market resilience: strength in numbers 1

4 VERY HEALTHY LABOR MARKET HIRES, QUITS AND JOB OPENINGS LEADING INDICATORS TO WAGE GROWTH Total Private Job Openings, Hires and Quits December 2003 December 2018 Seasonally adjusted, in thousands 7,000 6,000 5,000 4,000 3,000 2,000 1, Job Openings Hires Quits Source: Franklin Templeton Capital Market Insights Group and US Department of Labor. It seems like currently there is near-complete consensus that the United States is going to hit a recession by the end of this year or in 18 months. But I find it difficult to determine what is going to cause it within this timeframe. We do have a strong labor market, and we don t have by any means a hawkish Federal Reserve. The Fed is actually very dovish. Our team is also looking at energy prices, financial stability and asset price bubbles, and we don t see conditions setting up for a recession in the near term. I don t think the equity markets are pricing in a recession this year; I think they are pricing in the eventual recession in two years. Ed Perks If you look back six months or so to fourth-quarter 2018 both in the equity and credit markets we saw a pretty big dislocation. I would argue there may have been a point last year where risk assets were pricing in a near-term recession, but I m not sure that s actually the case today. I think the recovery since then has a lot to do with the pivot that the Fed made this year in moving to a more dovish tilt. The markets took a reprieve from that thinking, and we have seen a rally so far in At the end of last year the market was saying, We are likely to go into recession, the Fed s going to raise rates, we are worried about China and trade. Algorithms were unwinding with all this hedge fund activity, and then we have had this big bounce back in early From an equity-market point of view, I actually think things seemed to be a little bit too pessimistic a quarter or so ago, and perhaps now it s a little bit too optimistic. What do you make of the direction and impact of central bank policies globally? One of the concerns I have is that the recovery in risk assets we ve seen this year has come from the Fed succumbing to pressure to be dovish; the Fed reversed its view seemingly overnight. It can do that a couple of times perhaps, but at some point, the credibility of the institution is at stake. The United States has a very tight labor market, and wage-price inflation is now coming through. If the Fed is being directed to be dovish in the face of inflationary dynamics, that draws into question its institutional strength. From an equity-manager point of view, it almost looks like the Fed has three objectives right now inflation, wage growth and not letting the stock market fall too much. This is an issue. I think that concept actually goes even farther back. It started with former Fed Chairman Alan Greenspan decades ago, and it s always been alive and well. In fixed income markets, we saw US Treasuries sell off in 2018, so the Fed did not respond to US Treasuries, it responded to the equity market. I would actually say that s pretty dangerous. The 2 Market resilience: strength in numbers

5 Fed should not be targeting the equity market. There has not been a very good example of a central bank targeting asset prices and doing it successfully in a way that didn t ultimately prove detrimental. I think a lot of central banks in the developed world are behind the curve, with the Fed leading the way. Interestingly, some of the behavior on fiscal policy and on monetary policy in the United States is what we would usually see in emerging markets. What we are more focused on, however, is the unreasonable expectations for central banks. When you have populist, divided populations around the world, and governments and institutions are failing, a nation s central bank seems to be the one institution that s been tasked with solving everything. But the central bank can t solve income inequality, target inflation and target growth. It s just too many objectives. I think it goes to the fundamental issue that the breakdown of broader institutions might not be a problem when growth is good, but our team s concern is what happens when a crisis hits later. Thinking back to the global financial crisis over a decade ago, there were coordinated policy responses between China, the United States, Japan and Europe. These countries are barely talking now. What are you expecting for global growth? I think a catalyst would be needed to push the United States off its current growth path. I wouldn t anticipate gross domestic product (GDP) growth of 3.5% or 4% it seems likely to be less than that but we would need some trigger or shock to precipitate a recession, a bursting of a bubble. Recessions don t happen from old age alone. They really don t. I just don t see what the triggering mechanism for a recession would be right now. It s very odd right now to find such continued consensus about a near-term collapse of the US economy. Looking globally, we do see moderation in China s growth, but the government has such incredible control over the economy and over its capital flows, that a domestically led collapse seems pretty unlikely. Growth in Europe has been slowing down a bit, and some emerging markets outside of China may be a little weaker, but we don t see a massive downgrade of global growth as long as the United States can remain an anchor. China has been the fastest-growing major economy over the last 20 or 30 years, but not the best-performing stock market. That s particularly true today because there are other factors going on in China that are driving the market. One of those is that China s market is now being included in global equity benchmark indexes, and it s going to be included to such a degree that Chinese equities will represent upwards of half of the MSCI Emerging Markets Index. 1 So, if I were to look at a place of opportunity on the equity side right now, I would look at China and some of the changes that are going on and separate that from the economic news that China is slowing down a bit. Turning our eyes to Europe for a bit, there s been a lot of noise about the European slowdown. GDP growth in the eurozone is likely slowing to around 1.5% this year, but this is still substantially above European GDP growth potential. So it s certainly not a European-led global slowdown. Very rarely, apart from when we saw the eurozone debt crisis, has Europe really been at the forefront of the global move in any direction, so to speak. We don t see a massive downgrade of global growth as long as the United States can remain an anchor. 1. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging market countries. Market resilience: strength in numbers 3

6 Some of the slowdown in Europe is tied to Germany and Germany is very much tied to China s growth. When there is some clarity on tariffs, that could help Germany in particular, and European growth overall. Also, for equity investors there s a lot of concern about Brexit and what s happening in the United Kingdom. We don t know what s going to happen, but I think some clarity will help the markets. CHINA IS A KEY EXPORT PARTNER FOR GERMANY Germany s Top 5 Export Partners January 2009 January % 10% 8% 6% 4% 2% China USA France United Kingdom Netherlands Source: Franklin Templeton Capital Market Insights Group and International Trade Centre. Most recent data available. Let s talk about trade and politics. Specifically, could the trade conflict between the United States and China threaten growth in either of those countries? If you add up all the tariffs that could potentially happen and you carry that through to GDP, it s not trivial, but it is manageable. To me, the bigger concern is what drove these trade conflicts. It s a frustration of populations that don t want globalization and want to turn inward. Trade conflict is just one of the symptoms of a very difficult political dynamic in the United States and other countries that will also manifest itself in fiscal deficits and, in some places, authoritarian control. So this is just the beginning of what I think is a decade-long shift toward very unorthodox economic policies. Populism is a huge global issue. I find it amazing that Argentina is the only country that has passed a bipartisan budget of meaningful change that will run a surplus over the next couple of years. The only country that will embark upon landmark social security pension reform is Brazil. There s been a lot more talk than action on trade. Since President Trump came into power, we have been hearing about a trade war, but the war actually never took place. It s been fought out in the press, but, in fact, there has been very little outcome. I think it s far more important to actually consider those other areas of populism where trade is just one small piece of anti-globalization: its across-the-board immigration policy. Every policy you look at, there is this inward-looking nature to what s going on and not just in the United States. It s also happening in Europe. The issue with China, I think, is really a geopolitical issue that trade is a part of. My view is that as investors particularly equity investors really have to look at China in a way that, in the past, maybe you looked at Europe. Not as part of emerging markets, but as its own area that probably will make some sense to look at and be invested in over the longer period of time. But there is this dichotomy with the trade talks. The United States wants to reduce the trade deficit, but at the same time it s increasing the fiscal deficit. So as a country, if the US is going to lever itself if it is going to borrow all this money it is borrowing from other countries. That means the US is likely going to have trade deficits as the stimulus leads 4 Market resilience: strength in numbers

7 to increased spending. Putting tariffs on might reallocate the trade deficit, but it s not going to stop the trade deficit, in our view. For the fourth quarter of last year, the US had the highest trade deficit ever. HOW THE US AND CHINA TRADE DEFICIT HAS GROWN US Imports, Exports and Trade Balance with China 30 year period ending December 31, 2018 In billions (USD) Import of Goods from China (billions of USD) Export of Goods to China (billions of USD) Trade balance of goods with China (billions of USD) Source: Franklin Templeton Capital Market Insights Group and US Census Bureau. It sounds like markets may still have some upside, with economic growth still relatively strong in spite of slowdowns. Your thoughts? Ed Perks I think fundamentals remain a pretty favorable backdrop as long as global GDP sustains itself. I am not convinced markets are comfortable with the concept of further rate tightening and a further upward movement in rates. If we go back months when we saw interest rates move up particularly on the longer end of the yield curve, adjusting to the short-term interest rate increases the Fed was executing that s when we had bouts of equity-market volatility. I think it still remains to be seen if markets can get comfortable with the normalization of rates. October of last year really taught us that investors need to separate out broad market beta from idiosyncratic alpha that can deliver returns when markets falter. To think that the interest-rate shock we experienced in October will never happen again is not only wishful thinking, but also complacency. So our team s view is that we will get another period where, because of decent economic activity and gradually rising inflation, rates move higher and beta exposure likely won t perform particularly well. It will really separate out those investors who are identifying something unique or special whether it s a company or country situation, versus simply broad market risk. When all markets rise in such a quick snap back, people forget about events like last October. Our concern is that investors view that level of volatility as a one-off event, and don t consider that it will probably happen again. I fully agree. Going forward, I think the volatility component is the piece which has been most artificially suppressed over the last 10 years through central bank I think the volatility component is the piece which has been most artificially suppressed over the last 10 years through central bank action around the world. Market resilience: strength in numbers 5

8 action around the world. I tend to agree with Michael that we will see more Fed action because the Fed ultimately has to want higher rates when it eventually gets to the next recession in order to have that ammunition to fight it. Periods of volatility absolutely have to be expected. It s our job to try and navigate those periods, but they are going to happen. Ed Perks For active managers, some volatility can be good news. During periods of volatility, we can evaluate the opportunity set and select securities we believe are positioned to potentially outperform. Our clients increasingly want volatility management, so we have to strive to control volatility in our portfolios. It is a key element of our investment process. Our team would characterize a lot of the volatility that we have been seeing more recently as a return to more normal volatility in markets. This is coming after a period of really prolonged depressed volatility because of monetary policy and other factors. In the United States, I would also note that we have been a bit surprised just how quickly the 2020 presidential cycle has launched post last year s midterm elections. That s going to be a dominant theme in the media which contributes to uncertainty. And that uncertainty contributes to market volatility. The last 10 years of monetary policy has increased asset class correlations. As monetary policy normalizes, I think the differences between asset classes and company correlations will matter more. This means stock selection will add more value to the investment process. If markets tilt in favor of value, it will lead to a new set of companies leading the markets. 6 Market resilience: strength in numbers

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